Stocks, Bonds & Correlation Chaos: Rethinking the 60/40 strategy

Economic Times

10 hours ago

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The concept of the 60/40 investment portfolio , which typically refers to an allocation of 60% in stocks and 40% in bonds, has long been the cornerstone of investing by retail and institutional investors.It offered a simple and effective way to manage risk and return. However, there has been considerable debate about the effectiveness of this approach in the current economic environment, and whether it is 'dead' or still relevant.Traditionally, stocks and bonds have exhibited negative correlation. However, this correlation has fluctuated in recent years owing to various factors such as geopolitical events, inflation, and interest rates.When stock prices rise (indicating a healthy economy), bond prices often fall (as interest rates might rise in response to inflation concerns).Conversely, when stocks decline, bonds typically perform better as investors seek safety. We first saw this positive correlation in early 2020, when markets faced the uncertainty of the Covid-19 pandemic, and both stocks and bonds fell.From 2021 to 2022, the US Federal Reserve and other central banks began to raise interest rates aggressively to combat rising inflation. As rates increased, bond prices fell, and the stock market experienced volatility.This period saw periods of increased correlation, as both equities and bonds faced downward pressure from rising interest rates. Additionally, during times of geopolitical tensions (the Russia-Ukraine war, for example) stocks have often reacted negatively.Bonds, however, did not always act as a safe haven during these times, leading to instances of positive correlation.A perfect example of this correlation was in 2022 when both bonds and stocks posted significant losses. The S&P 500 (a common proxy for equities) was down 18%, and the Bloomberg US Aggregate Bond Index was down 13%.The combination of falling stock prices and rising interest rates resulted in a significant drawdown for the 60/40 strategy, an unusual deviation for this strategy.Many financial analysts and investors have begun to reassess the 60/40 approach due to its underperformance in recent years. The strategy's reliance on traditional asset classes has prompted discussions about diversifying into alternative asset classes such as real estate, commodities, hedge funds and private market investments.Alternative investments can provide exposure to asset classes that may not correlate with traditional investments like stocks and bonds, helping to mitigate overall portfolio risk. For instance, real estate, commodities, or infrastructure assets can serve as a hedge against inflation.While some argue that the traditional 60/40 portfolio is 'dead', it is perhaps more accurate to say that it may be less effective in an era marked by persistent inflation, geopolitical fragmentation, and policy uncertainty.Alternative strategies, revaluating asset classes, or shifting allocations based on economic indicators may be necessary going forward.Investors should regularly review their portfolios and potentially adapt to current and evolving market realities.Ultimately, the choice of investments will depend on individual risk tolerance, investment goals, and market conditions, making it essential to approach diversification with a well- considered strategy.(The author is Managing Director, International Business, LGT Wealth India)(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)